The Puzzle of Public Debt

We all know public debt matters.  Yet, no one knows how it exactly matters to economic growth. Does public debt cause growth?  Is there a tipping point?  Does the impact of debt on growth homogeneous for all countries? As researchers are struggled to answer these questions, here is a brief overview to unveil both the theoretical and the empirical innovations in the literature.

To well illustrate the impact of public debt on growth, let us review some basic national accounting identities.  First, from the private sector’s budget constraint, we have Y=C+S+T, where Y denotes national income, C is the private consumption, T is the after transfer payment government taxes.  Besides, since national income equals national output, for an open economy, we can express Y=C+I+G+NX, where I is the domestic investment, G denote government spending, and NX is net exports. Combining the above two identities, we realize the third identity, S+(T−G)=I+NX. Note that G−T is the government budget deficit. Hence, the third identity implies that the sum of private and public saving always equals the sum of investment and net exports. Based on how we understand the change in the third identity due to an increase in public debt, theoretically, economists focus on two views[1] that link public debt to economic growth in the long run.[2]

For decades, macroeconomists assume the Ricardian Equivalence holds. Therefore, they believe the effect of public debt on growth turns out to be neutral in the long run.  As shown in Barro (1974), the adverse impact of increasing public debt can be compensated by the positive effect of the instantaneous increase in private savings. This co-movement holds the national saving stay the same, and there is no extra driving force in growth. As the rise in S exactly equals the absolute value of the fall in T−G, the third identity keeps unchanged.

However, if the Ricardian Equivalence fails to hold, public debt can be detrimental to the economic growth, which forms a “Conventional view of public debt” as documented in Elmendorf & Mankiw (1999). If an increase in private savings cannot fully compensate for the drop in public savings, the third identity’s left side will be negative. To keep the identity still hold, we need to reduce domestic investment or net export of goods and services. First, let us consider I falls over time.  The decrease in the domestic investment results in lowering capital stock and further raising the interest rate by the higher marginal product of capital.  As the cost per unit of the capital increase, the marginal product of labour drops. As a result, both economic growth and the real wage income decrease accordingly.  Alternatively, if NX declines, by the national spending identity, economic growth also decreases.

On the practical side, many researchers have been working hard to examine whether we can verify the above-proposed links from the real data.  To name a few, Pattillo et al. (2003) find a negative effect of public debt on growth, whereas Panizza & Presbitero (2014) argues the adverse impact is vanished after correcting the endogeneity. Sanzo & Bella (2015) claim the linear causal effects between the public debt and the growth are heterogeneous across countries.

The work of Sanzo & Bella (2015) raises a critical question:  why we stick to find a uniform relationship between the public debt and growth and what if the connection is changing over time? Indeed, in an influential but controversial study, Reinhart & Rogoff (2010) find the relationship has an inverse-U shape. Specifically, they find if the public debt to GDP ratio is less than 90%, the impact of debt on growth is positive. However, the effect turns out to be harmful once the ratio surpasses the tipping point. They explain the finding as a debt overhang problem. Since then, 90% has become a magic number.  Policymakers debate whether they should use it as the government debt ceiling and academics replicated their study and questioned the validity of Reinhart & Rogoff (2010)’s data and methodology (e.g. Herndon et al. (2013)). More recently, by employing a more advanced econometric technique, Kourtellos et al. (2013) attribute this potential nonlinear impact to be endogenous, which perhaps arises from the bidirectional causality between debt and growth.  This finding provides us with new insight.  However, their results heavily rely on a strict assumption in their econometric model that is highly doubted in reality. As the latest dust-up still cannot fully address this issue, the puzzle continues.

Chaoyi Chen


Barro, R. J. (1974), ‘Are government bonds net wealth?’, Journal of Political Economy, 82(6), 1095–1117.

Delong, J. B. & Summers, L. H. (2012), ‘Fiscal policy in a depressed economy’, Brookings Papers on Economic Activity 2012(1), 233–297.

Elmendorf, D. W. & Mankiw, N. G. (1999), ‘Chapter 25 government debt’, Handbook of Macroe- conomics p. 1615–1669.

Herndon, T., Ash, M. & Pollin, R. (2013), ‘Does high public debt consistently stifle economic growth? a critique of Reinhart and Rogoff’, Cambridge Journal of Economics 38(2), 257–279.

Kourtellos, A., Stengos, T. & Tan, C. M. (2013), ‘The effect of public debt on growth in multiple regimes’, Journal of Macroeconomics 38, 35–43.

Panizza, U. & Presbitero, A. F. (2014), ‘Public debt and economic growth: Is there a causal effect?’, Journal of Macroeconomics 41, 21–41.

Pattillo, C. A. C. A., Poirson, H. & Ricci, L. A. (2003), ‘Through what channels does external debt affect growth?’, Brookings Trade Forum 2003(1), 229–258.

Reinhart, C. M. & Rogoff, K. S. (2010), ‘Growth in a time of debt’, American Economic Review, 100(2), 573–578. Sanzo, S. D. & Bella, M. (2015), ‘Public debt and growth in the euro area: evidence from parametric and nonparametric Granger causality’, The B.E. Journal of Macroeconomics 15(2).

[1] Recently, with the presence of hysteresis (cyclical shocks may permanently affect the output), Delong & Summers (2012) propose a third view that the public debt has a positive impact on growth through an expansionary fiscal policy in the long run. This link only affects a depressed economy. The authors review the government measures of the recent sovereign debt crisis and claim the austerity policy would further erode the growth of a highly indebted and depressed economy.

[2] A comprehensive survey can be found at Elmendorf & Mankiw (1999).

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